Chapter 5: The Open Economy

Chapter 5: The Open Economy Prof. Chris Foote Harvard University Department of Economics February 14, 2008 Foote (Ec 1010b) Open Economy February 14, 2008 1 / 70

Outline 1 International Flows of Capital and Goods 2 Saving and Investment in a Small Open Economy 3 Exchange Rates 4 The Large Open Economy Foote (Ec 1010b) Open Economy February 14, 2008 2 / 70

International Flows of Capital and Goods Trade Participation Ratios in 2004: (EX + IM)/GDP Country Ratio Luxembourg 275.5% Ireland 150.9% Sweden 83.8% Poland 80.0% Canada 73.1% Germany 71.1% Mexico 61.2% U.K. 53.8% France 51.7% Australia 39.6% U.S. 25.4% Japan 24.4% Foote (Ec 1010b) Open Economy February 14, 2008 4 / 70

International Flows of Capital and Goods Rearranging the national accounts identity C d : Consumption of domestically produced goods and services I d : Investment in domestically produced goods and services G d : Government purchases of domestically produced goods and services C d + I d + G d : Domestic spending on domestic goods and services EX: Exports of goods and services Y = ( C d + I d + G d) + EX Foote (Ec 1010b) Open Economy February 14, 2008 5 / 70

International Flows of Capital and Goods Making the identity more useful C f : Consumption of foreign goods and services I f : Investment in foreign goods and services G f : Government purchases of foreign goods and services C = C d + C f I = I d + I f G = G d + G f Y = ( C d + I d + G d) + EX Y = (C C f ) + (I I f ) + (G G f ) + EX Foote (Ec 1010b) Open Economy February 14, 2008 6 / 70

International Flows of Capital and Goods Making the identity more useful (con t) Y = (C C f ) + (I I f ) + (G G f ) + EX = C + I + G + EX (C f + I f + G f ) = C + I + G + (EX IM) = C + I + G + NX Note that IM = (C f + I f + G f )...... and EX IM = NX Foote (Ec 1010b) Open Economy February 14, 2008 7 / 70

International Flows of Capital and Goods Intuition behind national accounts identity Y = what is produced within U.S. borders (GDP) C + I + G = what gets used up within U.S. borders, regardless of where it comes from NX = net amount of stuff we send abroad Y = C + I + G + NX Y (C + I + G) = NX Foote (Ec 1010b) Open Economy February 14, 2008 8 / 70

International Flows of Capital and Goods Intuition behind national accounts identity (con t) Y (C + I + G) = NX If Y > (C + I + G): NX > 0 We send our excess stuff abroad We have a trade surplus If Y < (C + I + G): NX < 0 We get excess stuff from abroad We have a trade deficit If Y = (C + I + G): NX = 0 We have balanced trade Foote (Ec 1010b) Open Economy February 14, 2008 9 / 70

International Flows of Capital and Goods U.S. Exports and Imports 18.0 U.S. Exports and Imports 16.0 Exports Imports 14.0 12.0 Percent of GDP 10.0 8.0 6.0 4.0 2.0 0.0 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 Foote (Ec 1010b) Open Economy February 14, 2008 10 / 70

International Flows of Capital and Goods U.S. Trade Balance 2 Trade Balance (NX) 1 0-1 Percent of GDP -2-3 -4-5 -6-7 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Foote (Ec 1010b) Open Economy February 14, 2008 11 / 70

International Flows of Capital and Goods International Capital Flows Y = C + I + G + NX Y } {{ C G } = I + NX National Saving S = I + NX S I = NX An economy s NX must always equal the difference between its saving and investment } S {{ } I = }{{} NX Net Capital Outflow Trade Balance Foote (Ec 1010b) Open Economy February 14, 2008 12 / 70

International Flows of Capital and Goods International Capital Flows (con t) } S {{ } I = }{{} NX Net Capital Outflow Trade Balance Net capital outflow: Amount that domestic residents are lending abroad...... less the amount that foreign residents are lending to us. Note that net capital outflow is sometimes called net foreign investment Foote (Ec 1010b) Open Economy February 14, 2008 13 / 70

International Flows of Capital and Goods Is a trade deficit bad? The U.S. has a trade deficit By definition, that must mean that S I is in the U.S. is negative Many people believe that low private saving and low public saving in the U.S. are a problem Others believe that S I < 0 because foreigners are attracted to investment opportunities here Don t really know whether S I = NX < 0 is a problem without more information Foote (Ec 1010b) Open Economy February 14, 2008 14 / 70

International Flows of Capital and Goods Saving, Investment, and Net Exports: 1960-2006 25 20 Investment 15 Saving Percent of GDI 10 5 0-5 Net Exports -10 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Foote (Ec 1010b) Open Economy February 14, 2008 15 / 70

International Flows of Capital and Goods 25 Gross Saving Rates: 1960-2006 20 Private 15 Percent of GDI 10 5 Government 0-5 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Foote (Ec 1010b) Open Economy February 14, 2008 16 / 70

International Flows of Capital and Goods Forms of Foreign Investment into the U.S. 1 Foreigners making loans by buying U.S. debt Lending to U.S. treasury via purchase of a Treasury bond... or corporations via corporate bond or commercial paper... or U.S. homeowners via mortgage-backed securities 2 Foreigners purchasing U.S. assets Rockefeller Center Stake in Citibank or other investment banks Shares of stock in U.S. companies In either case, foreigners obtain claims to future returns of the U.S. capital stock Foote (Ec 1010b) Open Economy February 14, 2008 17 / 70

International Flows of Capital and Goods An intuitive example Think of a U.S. resident buying an ipod from China for $100: NX falls A Chinese citizen then receives $100 U.S. dollars What will he do with the money? 1 Stick it in the mattress? This is an investment in the U.S. economy by the Chinese resident U.S. net capital outflow (S I) declines (because there has been an inflow of capital into the U.S.) 2 Purchase share of U.S. corporation or U.S. Treasury bond? Same as #1 3 Buy an American good worth $100? U.S. exports rise, so NX rises Ultimate effect of ipod purchase and offsetting purchase of U.S. good is no change to NX or S I Foote (Ec 1010b) Open Economy February 14, 2008 18 / 70

International Flows of Capital and Goods Irrelevance of Bilateral Trade Balances } S {{ } I = }{{} NX Net Capital Outflow Trade Balance Note that this identity holds for the world as whole, not for individual countries A country with S I = NX > 0 might run a large trade deficit with a single trading partner...... but multilateral trade position must be in surplus if S I > 0. Bilateral trade balances don t matter Example: Solow s barber Foote (Ec 1010b) Open Economy February 14, 2008 19 / 70

Saving and Investment in a Small Open Economy The Small Open Economy (SOE) and r 1 SOE is small its own S and I have little effect on world real interest rate: r World r is set to equilibrate world saving and world investment SOE is too small to affect this balance SOE s own S need not equal its own I, so NX need not equal zero 2 SOE has perfect capital mobility: Domestic r is equal to world r Borrowers would never borrow at a higher r than r Lenders would never lend at a lower r than r So, r = r Foote (Ec 1010b) Open Economy February 14, 2008 21 / 70

Saving and Investment in a Small Open Economy The Model As before, economy s output is pinned down by F(K, L): Y = F(K, L) = Y As before, consumption depends on disposable income: C = C(Y T) = C(Y T) As before, investment is negatively related to real interest rates: I = I(r) But, we are now assuming that r is SOE is equal to world real interest rate: r = r Foote (Ec 1010b) Open Economy February 14, 2008 22 / 70

Saving and Investment in a Small Open Economy The National Accounts Identity Revisited (Y C G) I = NX [Y C(Y T) G] I(r ) = NX }{{} National Saving Y = C + I + G + NX S I(r ) = NX NX depends on variables that determine difference between S and I Fiscal policy (G and T ) World real interest rate r Any autonomous movers of C or I (e.g., wealth for consumption) Foote (Ec 1010b) Open Economy February 14, 2008 23 / 70

Saving and Investment in a Small Open Economy Saving and Investment in an SOE Foote (Ec 1010b) Open Economy February 14, 2008 24 / 70

Saving and Investment in a Small Open Economy Policy Experiment #1: Fiscal Expansion at Home Consider situation if SOE increases G Direct reduction in national saving (S), because S = Y C G Savings schedule shifts to the left No change in r, because SOE assumption says economy is too small to affect world S or I No change in I(r ) S I = NX, so fall in S moves NX toward deficit Foote (Ec 1010b) Open Economy February 14, 2008 25 / 70

Saving and Investment in a Small Open Economy Pol. Exp. #1: Fiscal Expansion at Home Foote (Ec 1010b) Open Economy February 14, 2008 26 / 70

Saving and Investment in a Small Open Economy Policy Experiment #2: Fiscal Expansion Abroad Consider situation if rest of the world (ROW) increases G No change in SOE s national saving: S = Y C G However, higher world G means smaller world G and higher world r Higher world r reduces I(r ) at home S I = NX, so fall in I moves NX toward surplus Foote (Ec 1010b) Open Economy February 14, 2008 27 / 70

Saving and Investment in a Small Open Economy Pol. Exp #2: Fiscal Expansion at Abroad Foote (Ec 1010b) Open Economy February 14, 2008 28 / 70

Saving and Investment in a Small Open Economy Policy Experiment #3: Shift in Investment Demand Assume that animal spirits (φ) rises: I(r) = φ d r Demand for investment goods at given r increases Investment schedule I(r ) shifts up and to the right No change in S = Y C G S I = NX, so rise in I moves NX toward deficit Foote (Ec 1010b) Open Economy February 14, 2008 29 / 70

Saving and Investment in a Small Open Economy Pol. Exp. #3: Shift in Investment Demand Foote (Ec 1010b) Open Economy February 14, 2008 30 / 70

Nominal Exchange Rate Definition The nominal exchange rate is the relative price of the currencies of two countries. We will define nominal exchange rate as: e = $ If e gets bigger, then it takes more to get one dollar Dollar strengthens relative to the yen Foote (Ec 1010b) Open Economy February 14, 2008 32 / 70

Dollar vs. Yen Exchange Rates Foote (Ec 1010b) Open Economy February 14, 2008 33 / 70

Euro NOT as Mankiw defines e Foote (Ec 1010b) Open Economy February 14, 2008 34 / 70

Pound NOT as Mankiw defines e Foote (Ec 1010b) Open Economy February 14, 2008 35 / 70

Nominal Trade-Weighted Value of the Dollar 140 120 e = 4N curr / $ (as in Mankiw's text) 100 Index (Jan 1997 = 100) 80 60 40 20 0 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Foote (Ec 1010b) Open Economy February 14, 2008 36 / 70

Real Exchange Rate Definition The real exchange rate is the relative price of the goods of two countries. How many Japanese goods does it take to get one U.S. good? How many U.S. goods does it take to get one European good? Foote (Ec 1010b) Open Economy February 14, 2008 37 / 70

Calculating the real exchange rate American basketball costs $12 Japanese basketball costs 1000 yen Nominal exchange rate = 100 yen / dollar How many Japanese basketballs is one U.S. basketball worth? Real exchange rate = (100 yen/dollar) ($12/U.S. basketball) 1000 yen/japanese basketball Real exchange rate = 1.2 Japanese basketball U.S. basketball Foote (Ec 1010b) Open Economy February 14, 2008 38 / 70

Calculating the RER (con t) RER = (Nominal exch rate) (Price of Domestic Good) Price of Foreign Good RER = (Nominal exch rate) (Ratio of Price Levels) ǫ = e P P P = Domestic Price Level P = Foreign Price Level Foote (Ec 1010b) Open Economy February 14, 2008 39 / 70

Avoiding confusion in exchange rates Note that we have defined both the nominal and real exchange rate so that higher numbers mean that the U.S. goods or dollars are stronger Nominal exchange rate = $ Example: e = 100 means that it takes 100 yen to get one dollar If e rises to 120, that means it takes more yen to get one dollar The dollar has therefore strengthened with respect to the yen Foreign goods Real exchange rate = American goods Example: ǫ = 1.0 means that it takes 1.0 Japanese goods get one American good If ǫ rises to 1.2, that means it takes more Japanese goods to get U.S. good The U.S. real exchange rate has therefore strengthened with respect to Japan Foote (Ec 1010b) Open Economy February 14, 2008 40 / 70

Real exchange rate and NX Real exchange rate is a relative price Higher real exchange rate means that it takes more foreign goods to get one U.S. good Foreign goods are therefore cheaper than U.S. goods Net demand for foreign goods would be expected to be stronger (other things equal)...... because demand curves slope down We therefore define our NX function as: where higher ǫ reduces NX NX = NX(ǫ) Foote (Ec 1010b) Open Economy February 14, 2008 41 / 70

Net Exports and the Real Exchange Rate Foote (Ec 1010b) Open Economy February 14, 2008 42 / 70

Real Trade-Weighted Value of the Dollar 140 120 = e (P / P*) (as in Mankiw's text) 100 Index (Jan 1997 = 100) 80 60 40 20 0 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Foote (Ec 1010b) Open Economy February 14, 2008 43 / 70

Real Exchange Rate and Net Exports 140 2 Index (Jan 1997 = 100) 120 100 80 60 40 = e (P / P*) (as in Mankiw's text) [right scale] 1 0-1 -2-3 -4-5 Percent of GDP 20 NX (left scale) 0 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006-6 -7 Foote (Ec 1010b) Open Economy February 14, 2008 44 / 70

Determinants of Real Exchange Rate We know that ǫ is negatively related to NX We know that NX must equal the net capital outflow, which is just S I Saving: S = Y C(Y T) G Investment: I = I(r) = I(r ) Neither of these items are depend on ǫ Foote (Ec 1010b) Open Economy February 14, 2008 45 / 70

Net Exports and the Real Exchange Rate Foote (Ec 1010b) Open Economy February 14, 2008 46 / 70

Supply and Demand for Foreign Currency We can think of previous graph in supply and demand terms S I: Net supply of dollars to be exchanged for investment abroad NX: Net demand for dollars from foreigners who want to buy our goods Foote (Ec 1010b) Open Economy February 14, 2008 47 / 70

Policy Experiment #1: Fiscal Expansion at Home Consider an increase in G or a decrease in T Either one of these movements will reduce S Neither of these movements will change I I = I(r) = I(r ) Small open economy does not affect r, so no r or I S I = NX is reduced Foote (Ec 1010b) Open Economy February 14, 2008 48 / 70

Policy Experiment #1: Fiscal Expansion at Home Foote (Ec 1010b) Open Economy February 14, 2008 49 / 70

Pol. Exp. #1: Fiscal Expansion at Home (con t) Y = C(Y T) + I(r ) + G + NX When fiscal expansion occurs via rise in G: No change in C(Y T) No change in r or I Decline in NX, so NX are crowded out by higher G Y = C(Y T) + I(r ) + G }{{} rises + NX(ǫ ) }{{} falls When fiscal expansion occurs via drop in T : Increase in C(Y T) No change in r or I Decline in NX, so NX are crowded out by higher C Y = C(Y T ) +I(r ) + G + NX(ǫ ) }{{}}{{} rises falls In closed economy case, it is I, not NX, that gets crowded out Foote (Ec 1010b) Open Economy February 14, 2008 50 / 70

Policy Experiment #2: Fiscal Expansion Abroad Fiscal expansion abroad raises r This will have no effect on S Higher r will reduce I S I is increased, ǫ declines, and NX rises Foote (Ec 1010b) Open Economy February 14, 2008 51 / 70

Policy Experiment #2: Fiscal Expansion Abroad Foote (Ec 1010b) Open Economy February 14, 2008 52 / 70

Pol. Exp. #2: Fiscal Expansion Abroad (con t) Y = C(Y T) + I(r ) + G + NX When fiscal expansion occurs abroad, r increases No change in C(Y T) Increase in r reduces I Lower ǫ increases NX to offset drop in I Y = C(Y T) + I(r ) }{{} falls +G + NX(ǫ ) }{{} rises Foote (Ec 1010b) Open Economy February 14, 2008 53 / 70

Policy Experiment #3: Shift in Investment Demand Think of an increase in animal spirits (φ) in I = φ d r Investment rises at each interest rate r does not change, so overall I increases S I is decreased, ǫ rises, and NX declines Foote (Ec 1010b) Open Economy February 14, 2008 54 / 70

Policy Experiment #3: Shift in Investment Demand Foote (Ec 1010b) Open Economy February 14, 2008 55 / 70

Pol. Exp. #3: Shift in Investment Demand (con t) Y = C(Y T) + I(r ) + G + NX With a shift in investment demand and no change in r, I increases No change in C(Y T) Increase in I No change in G Higher ǫ reduces NX to offset increase in I Y = C(Y T) + I(r ) }{{} rises +G + NX(ǫ ) }{{} falls Foote (Ec 1010b) Open Economy February 14, 2008 56 / 70

Policy Experiment #4: Import Restrictions Think of a tariff or quota that makes it harder for Americans to import goods Unless policy affects S or I, it cannot affect S I = NX Trade policies can reduce imports and raise net exports at any given ǫ, however Foote (Ec 1010b) Open Economy February 14, 2008 57 / 70

Policy Experiment #4: Import Restrictions Foote (Ec 1010b) Open Economy February 14, 2008 58 / 70

Pol. Exp. #4: Import Restrictions (con t) Y = C(Y T) + I(r ) + G + NX Trade restrictions that would tend to increase NX are offset by increase in ǫ that reduces NX No change in C(Y T) No change in I No change in G No change in NX Y = C(Y T) + I(r ) + G + NX(ǫ ) }{{} stays the same Foote (Ec 1010b) Open Economy February 14, 2008 59 / 70

Determinants of Nominal Exchange Rate We can rearrange our equation for the real exchange rate: ǫ = e P P...... to become an equation for the nominal exchange rate: e = ǫ P P Our rules for percentage changes of products and quotients imply % e = % ǫ + (π π) A country with a high rate of inflation relative to the U.S. will see its currency weaken relative to the dollar Makes sense: If the other country is printing lots of money, its currency become relatively less valuable Foote (Ec 1010b) Open Economy February 14, 2008 60 / 70

Inflation Differentials and Nominal Exchange Rates: 1972-2004 Foote (Ec 1010b) Open Economy February 14, 2008 61 / 70

Purchasing Power Parity (PPP) Consider a world without trade frictions, transport costs, and perishable goods In this world, the law of one price would hold A U.S. good would trade for a Chinese good, as long as the goods were the same ǫ = e P P = 1 Net exports would be extremely sensitive to real price differentials NX(ǫ) schedule would be very flat Foote (Ec 1010b) Open Economy February 14, 2008 62 / 70

Purchasing Power Parity Foote (Ec 1010b) Open Economy February 14, 2008 63 / 70

Implications of PPP Exchange Rates 1 Because NX(ǫ) schedule is flat, S I does not affect ǫ or e 2 Because ǫ = 1, all changes in e result from changes in price levels ǫ = e P P = 1 e = P P We can use this last implication to devise a test of exchange rates, to see if they are undervalued or overvalued Find a good that is sold in the two countries Find P P and compare to e If e < P P, then dollar is undervalued relative to foreign currency If e > P P, then dollar is overvalued relative to foreign currency Good often used for this test? Big Mac Foote (Ec 1010b) Open Economy February 14, 2008 64 / 70

Figure 1. A Big Mac c Foote (Ec 1010b) Open Economy February 14, 2008 65 / 70

Big Mac Test: Some examples (from Table 5-2) Price of Predicted e Actual Dollar is Over Country Big Mac ( P P ) e or Under Valued? U.S. 3.06 Indonesia 14,770? 9,654? China 10.5? 8.48? U.K. 1.89?.55? Foote (Ec 1010b) Open Economy February 14, 2008 66 / 70

Big Mac Test: Some examples (from Table 5-2) Price of Predicted e Actual Dollar is Over Country Big Mac ( P P ) e or Under Valued? U.S. 3.06 Indonesia 14,770 4,771 9,654 Over China 10.5 3.43 8.48 Over U.K. 1.89.61.55 Under Foote (Ec 1010b) Open Economy February 14, 2008 67 / 70

Verdict on PPP Exchange Rates Predictions are often in the ballpark...... but often far from the mark PPP turns out to hold better in changes than in levels Levels (less support): e = P P Changes (more support see Figure 5-13): % e = π π Foote (Ec 1010b) Open Economy February 14, 2008 68 / 70

The Large Open Economy Large Open Economy U.S. is like an intermediate case between closed economy and SOE A reduction in U.S. saving raises U.S. interest rates (r vs. r ) But U.S. is not immune to international developments Turns out that we can think of U.S. as an average of two polar cases Example: Increase in U.S. G (fiscal expansion) U.S. saving declines U.S. r rises (as in closed economy case) I U.S ǫ rises (as in SOE case) NX Closed Economy Case: Y = C + I +G Small Open Econ Case: Y = C + I + G +NX Large Open Econ Case: Y = C + I +G +NX Foote (Ec 1010b) Open Economy February 14, 2008 70 / 70